Thursday, June 26, 2008

Red Hat (RHT) Accelerates Growth

Red Hat's stock price plunged today with most of the rest of the tech stocks. Perhaps RHT investors were overly optimistic about quarter results released yesterday, or they did not think Red Hat's guidance was robust enough. I think Red Hat is doing great. That said, it has a relatively high price/earnings (PE) ratio for this market. If growth flattens, that PE will need to come down.

However, if anything Red Hat growth is accelerating. It may even have been helped rather than hurt by the current macroeconomic environment. Its Red Hat Enterprise Linux operating system and JBossmiddleware offer great value propositions for companies using a lot of data servers; the more servers, the greater the savings over competitors. We have a growing server market combined with Linux variations continuing to win market share from Unix and Microsoft OSs. It is a pretty rich field to plow.

Q1 2008 revenues were $118.9 million, up 7% sequentially and up 42% from year earlier.

Two things: annual growth slowed to a mere 32% from 42% for the quarter year-earlier. On the other hand sequential growth (Q4 to Q1) increased from 7% to 11%.

You could read too much into such figures since Red Hat revenues are still small enough to be impacted by single deals, or income recognition that slips from the end of one quarter into the beginning of the next. But the 11% sequential growth is better than recent annual growth rates in a quarter that is not normally a strong quarter.

I think Red Hat has an ideal combination of high-quality, robust, easy to manage products and low pricing compared to rivals. There is plenty of competition for Linux server software, but Red Hat has established itself as the premium brand without charging premium prices.

With IT departments desperately needing to innovate to keep pace with the data explosion (driven in part by audio and video data), Red Hat offers open source solutions that are at least as well-tested and capable as proprietary solutions. With IT budgets strained and CEOs demanding high returns on investment, Red Hat software begins to look like a bargain.

The main danger to Red Hat is the possibility of a larger company using its financial muscle to sell competing software and services at uncompetitive prices. Microsoft (MSFT) could afford to do this, as could Oracle (ORCL), but they are locked in struggle with each other as well as SAP and IBM. Novell (NOVL) is treading in Red Hat's footsteps, but they don't have any profits to fight with. Sun (JAVA) is becoming an open source powerhouse, but their profits come from their hardware arm, which is still struggling.

So Red Hat is a risky stock and is not dirt cheap right now. It was cheaper when I bought some earlier this year. It has its risks, but I believe over a 2 to 3 year time horizon the risks are minimal and their is a great potential upside. Management seems to think the main constraint lately has not been demand, but the ability of its sales force to keep up with demand. That is not a bad problem to have.